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Money in, Money Out

How to time cash flow to make the most of the cash in your company - both your own and other people's.
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As any forward-thinking manager will tell you, the trick to handling cash flow is in the timing. Here's how to think about making the most of the cash in your company -- both your own and other people's

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The riddle of the Sphinx of Thebes has nothing on the riddle of the flow of cash. For ages accounting organizations have been struggling to pin down a functional definition of cash flow. Here's what the auditing crowd has come up with: cash flow = net income + depreciation + amortization + depletion + deferred taxes + an assortment of other noncash figures. The theory is that restoring to income a noncash item previously taken as an expense presents a truer financial picture than the simple income statement does.

Unfortunately for a business trying to keep pace with its creditors, vendors don't accept such income-statement dollars as payment for real goods. In which case, one street-hardened entrepreneur we know has a better theory: Anyone who relies on an accountant for cash-flow projections should be shot.

A bit harsh, no doubt. Yet much the same conclusion must have been reached by the principals of Chesapeake Biological Laboratories Inc. (CBL), a pharmaceutical company in Baltimore, after they raised $3 million in a 1988 initial public offering. The founders hired "some business types," as cofounder and current chairman William Tew alludes to them, to spend the cash wisely. Within 18 months the business types had spent the company into insolvency.

Any grammar-schooler can predict that if you can't buy lemons, you can't sell lemonade. As far as cash flow goes, putting out more money than you take in doesn't do the trick, no matter how dazzling the bookkeeping behind it. CBL's owners, who have medical backgrounds, admittedly were blinded to the drain on real cash by "the language of accounting, which," Tew sheepishly explains, "was something that, as scientists, we didn't find meaningful."

What the good doctors did find meaningful was that CBL got thrown off NASDAQ for failing to maintain minimum net worth -- "minimum" meaning just about nil. They took out personal lines of credit to keep their company afloat, dismissed their crack financial team, and struck out on their own.

Basically, the expression cash flow denotes only that cash leaves a company's beginning cash balance, does something for a while to attract customers, and returns as the company's ending cash balance, either augmented or diminished. But have Generally Accepted Accounting Principles or the Financial Accounting Standards Board outlined pathways for that cash to take?

"When we went to our external accountants for advice on how to manage cash in a forward-looking way," Tew complains, "they insisted on describing what our financial situation was. But we needed something that anticipated how our cash account would stand at a given point in the future, a tool that could give us predictions."

Enter functional cash-flow analysis. Since no one has convincingly defined what proper management of cash flow can do, not to mention what it is, for the moment we'll call our analysis of it the study of the influence of business decisions -- or lack of them -- on a company's cash account at given points in the future.

Cash-flow management actually is cash management -- except the cash being managed may not yet have arrived. Cash-flow management can be as rudimentary as preserving future cash by not spending so much in October if December -- when October's bills will come due -- is traditionally a poor sales month and won't generate enough receipts to cover those bills.

The goal of good cash-flow management ought to be obvious: to have enough cash on hand when you need it. It's a simple concept, yet in practice it eludes even the biggest of operations. Industry almost lost Chrysler and Lockheed for lack of cash, and did lose Penn Central and Pan Am. The problem is, cash-flow analysis doesn't yield to intuition because it involves tomorrow. Profit is a friendlier concept, in that it's calculable right now and you don't have to have a business to produce it. In 1992 a company could have drained its cash account directly into securities yielding 8%, and -- without fussing over jobs, office space, equipment, or sales of a product -- received double the net profit margin of the average NASDAQ-listed corporation (which was 4% as of December 1992).

But that's no fun. Besides, it wouldn't work if everybody did it. Fortunately, entrepreneurs prefer the second-mortgaging, nickel-scrounging grind of running bona fide businesses. That's where the leveraging muscle of our kind of cash flow comes in, as invested capital meanders through raw materials, loan obligations, variable costs, machinery, taxes, and similarly quantifiable components of everyday commerce. By deftly playing one such element against another, you can harness other people's capital without their knowing it and dig up capital you never knew you had. You can think of cash-flow-engendered capital as a kind of magical purchasing power, since it's nothing you can log into your income statement, and if mishandled, it will disappear.

Given the twists and turns around which cash flows through the innards of a business -- each new direction determined by the last -- we can't detail specific cash-flow-management techniques in the limited space we have. Instead, we'll outline concepts that will get you started on thinking about those techniques. A device so marvelous that it can invest someone else's money in your company and convert someone else's working capital to your cash is well worth thinking about, don't you agree?

As an introductory mind stretcher, let's solve some third-grade arithmetic.

The Zen of Cash Flow: Quiz Number 1
As it passes over a bridge exactly one mile long, your car travels the first half at 30 miles per hour. How fast do you have to travel over the second half to average 60 miles per hour for the entire span? Try 90 miles per hour for the second half, add it to the first half's 30 miles per hour, and divide by two to get the average. Sure enough, it's 60 miles per hour.

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But don't even bother pressing your foot to the pedal if that's your answer -- you've made the wrong assumption.

Someone with a cash-flow-oriented mind-set, who evaluates one phase at a time, recognizes the above problem as a question of the passage of time, rather than one of adding and averaging. To average 60 miles per hour over the mile-long bridge requires one minute. In traveling the first half-mile at 30 miles per hour, the car uses up that minute. However achievable- sounding it may be, your modest goal of averaging 60 miles an hour going over the bridge can never be achieved.

It's the nature of businesspeople to add up quantities and to draw from them "average" conclusions. But not all average-based numbers are significant. It would be a negligent business indeed that was satisfied that its two-person sales force was spending an industry-standard average of two hours to make $1,000 worth of sales, when one salesperson averaged 10 minutes to produce $500, and the other averaged 110 minutes. Every month, someone (or something) tugs at your sleeve for a cash handout: loan officers, employees, suppliers, landlords, tax collectors. There's no point in averaging any of those costs, because the stark fact is that if you don't have cash at a crucial point in the chain of demands, you're finished. An alert cash-flow manager keeps an eye not on cash receipts or on cash demands as average quantities but on cash as a function of the calendar.

On an income statement, uncollected receivables are considered revenues and are a component of measuring a company's performance from one reporting period to another. But in cash-flow analysis, receivables are worthless until they turn into real money. Accounts-receivable turnover determines when you'll have cash to meet payables and other obligations. Because cash-flow analysis tracks cash over periods of time -- essentially, when cash in must go back out -- the projection of how many days it takes for your business to convert receivables to cash is a significant number. Here's the basic calculation: divide your annual sales by 360 to get one day's sales; then divide the amount of your receivables by one day's sales to get the number of days it takes your customers to pay you. For example, $5.2 million in annual sales ÷ 360 days = $14,444; $750,000 in receivables ÷ $14,444 = 51.9 days. If, by similar calculation, you're paying your suppliers in 60 days, you're getting 8.1 days' free use of their money.

Dollar amount (either coming in or going out) per time period is the crucial cash-flow consideration. When creditors demanded that CBL attend to arrears, Tew was at first tempted to agree to whatever terms creditors proposed, just to buy time and stay alive a little longer. On careful reconsideration, he saw that making payroll was critical; failing to do so along the way would be "absolutely terminal," no matter what potential lay beyond. "It was kind of chicken-or-egg," Tew says. "We had to spend in order to dress ourselves up to attract business, yet we couldn't afford to get on the wrong side of the curve."

Tew devised a what-if spreadsheet to consider the effects of chains of events. The model traced the stage-by-stage impact on the company's cash account of proposed business decisions -- advanced payments, hiring, royalties, pricing, and so on. With it he was able to compare when he'd need a certain amount of cash to invest in operations with projections of when that cash would come back out as revenues. Forecasting how much cash would be available for delinquent payables on which dates, the computer countered vendors' undoable demands with doable schedules. CBL made good on every dime it owed.

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The aim of prudent cash-flow management is to make sure there'll be enough cash in the till to meet given demands for that cash at any given time. That aim is fulfilled through the type of conservative reasoning touched on above, in which the objective is to keep real cash flowing into the till by means of operations and disciplined spending. But cash also can be brought to the bottom line by aggressively tapping capital that essentially belongs to others and putting it to work -- legally, if briefly -- as if it were your own.

Skillful cash-flow management can parlay a dollar's worth of intangible values no auditor would let you call assets -- things like advantageous accounts-payable terms, products that can be churned out rapidly and sold quickly -- into more than a dollar's worth of purchasing power. Of course, a bank loan provides much the same leverage, except for two burdensome differences, as the leveraged-buyout craze of the 1980s exposed: a bank requires tangibles, and you have to repay a bank.

Here's cash flow's fundamental leverage rule, as practiced by bootstrappers through the centuries: Get your customers to pay you as soon as possible (preferably in advance). Get your vendors to let you take your sweet time paying them (preferably within several months: vendors want to grow, too, and often will be patient just to get your business).

The premise is that every dollar collected in receivables this morning that isn't needed for payables until tonight is yours to multiply all day. A business might take advantage of that otherwise fallow interval by buying raw material with the dollar at 9 a.m., manufacturing something out of that material, and selling the finished item for $2 at 10 a.m.; buying twice as much material with the $2 it now has and selling two items for $4 at 11 a.m.; buying four times as much material for $4 and selling four items for $8 at noon, and so on. At that rate, by 5 p.m., when the dollar must be dispatched to its now-rightful owner, the company has 255 more dollars than it had at 9 a.m. Subtract labor and variable costs, and you're still way ahead.

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The Zen of Cash Flow: Quiz Number 2
To appreciate that even a modest sum of such internally generated working capital is worth leveraging, take a quick guess as to how many dollars end up in the 64th square of a chess board if you start with a mere two pennies in the first square and double the result sequentially through each of the remaining squares. Would the final amount be (1) $128.75; (2) $8,112.50; or (3) $184,467,440,737,095,516.16?

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If you picked (1) or (2), invest your cash in Treasury bonds and take a salaried job. If you chose (3), the correct sum, you're ready to move on to larger reflections on cash-flow strategy.

The preceding illustrates the cash-flow principle of converting someone else's money into your working capital. Next: the cash-flow principle of converting someone else's working capital into your money.

Let's say your company habitually mails its weekly invoices a week late, owing to an overtaxed office staff. No big deal, to a modest enterprise; the delay in billing merely delays receipts by the same interval. But consider the example on a slightly grander scale. When a business that's doing $5.2 million in annual sales fails to collect a week's worth of receivables -- $100,000 -- on time, it fails also to collect $190 from 0.19% weekly interest each week on $100,000 at 10% (an interest rate slightly increased here for ease of calculation, but destined to be back soon). To most observers, the cost of the week's laxity is naught, because the amount the business doesn't collect doesn't appear on a financial statement, inasmuch as to an auditor it doesn't exist.

To a student of cash flow, however, it does exist: the company's cash receipts are demonstrably short $190 each week. In a year, that adds up to about $10,000.

It's the nature of small businesses to favor cost saving over cost making, but don't assume that not spending cash is the equivalent of protecting cash. Judicious spending can enhance cash flow, returning yet more cash in the timely fashion that positive cash flow calls for. If, instead of draining the cash account by our elusive $10,000, you spend a concrete $2,000 on hiring a temporary office worker to dispatch invoices promptly, wouldn't there be an actual gain of $8,000 in the year's ending cash balance? You bet -- and that's working capital that shortsighted management had unwittingly thrown away.

Now we're on a roll. If so modest a spend-now-gain-later campaign has a positive reward, what would that company's cash future look like if it spent $10,000 for a computerized billing system? We can't tell just yet. As cash stakes rise, so do the variables of cash flow that affect it. No matter how convoluted, cash-flow analysis can deliver significant rewards; companies satisfied to leave well enough alone may actually be losing ground. So don't shoot your accountant -- you need one to evaluate such influences on cash flow as, yes, depreciation. This time, though, the accountant will be looking forward.

To determine cash flow's most productive path, here's the pure-cash starting point: $10,000 amortized over five years is $166.67 a month, all else being equal. Because you withdrew that $10,000 from your cash account, add to the actual cost the $83.33 a month that would have been earned in interest (at 10%). Cash cost: $250 a month. Pure-cash conclusion: if the system saves $190 a week, it's worth the investment.

But in cash-flow analysis, all else never is equal. Among the dozens of cash-affecting permutations that complicate a decision, some -- such as your tax rate, interest rates, and payment terms -- really complicate a decision.

We're no accountant, nor do we play one on TV. So we'll skip intervening scenarios -- a capital lease, for example -- and cut to the chase. The mean-and-lean business doctrine dictates that a company owning a machine that processes accounts more efficiently than a human does will retire that human. Trim payroll by $21,500 annually, drop payroll-associated costs by another $1,500, and pare general and administrative costs a couple of hundred dollars more. When you calculate it that way, your computer not only costs nothing but also returns a good $20,000 the first year alone to the cash account -- where the sum earns another $2,000 in interest. (For the sake of illustration, we've pretended you haven't put that money to work elsewhere at a higher return. But remember, an adroit cash manager doesn't let an excess of cash hang around uninvested; conversely, the mistakes of an maladroit manager are easily covered up by excesses of uninvested cash.)

* * *

All this is academic unless you have cash in the first place. To many businesspeople, the lack of starting cash would seriously impede the accumulation of ending cash. Luckily, one of the major opportunities that cash-flow "financing" offers is that the beginning cash doesn't have to be yours.

A business can get customers to part with their money well before that business has to deliver the paid-for product. And that product needn't be exotic. Trash-collecting businesses bill customers for each coming quarter; no money, no removal. Insurance companies take in a year's worth of money, invest it elsewhere, then sit back and hope nothing bad happens. A monthly magazine like Inc. may receive payment for a year's subscription but is required to manufacture only a slim one-twelfth of the prepaid-for product per month. Money that's not immediately needed enters the cash-flow chain, for better or worse.

The challenge in those situations is apportioning the prepayment to meet the capital needs over time. No problem -- on paper. Many a magazine publisher hasn't made it, however, after having wrongly assumed that the cash-flow setting of each magazine cycle equals that of the next. Instead, each cycle affects the next, and managers have to understand how, if they are to be prepared for changing cash needs.

The Zen of Cash Flow: Quiz Number 3
At the start of five-card stud poker, you're twice as likely to be dealt a straight (254-to-1) as a flush (508-to-1). Therefore, you'd bet those 2-to-1 odds when you have four cards to a straight and your opponent has four to a flush, right?

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Wrong. Hold that raise. As the cards are dealt and the hand develops, the relationship shifts. What the odds are at the beginning doesn't mean a thing once the cards start coming. If you are an astute player, you'll look ahead, calculating the new odds as the game continues. When it's time for the fifth and last card, the odds have changed radically; with four cards to a straight already in your hand, there are eight cards that can fill it -- four at each end. Not bad odds -- except that the advantage now goes to the hand with four to a flush, which any one of nine cards will fill.

The most enviable cash-flow position -- cash coming in that entails no cash going out -- has been attained by one clever company that receives payment for a product it sometimes never has to deliver. The product (it's actually on the market) is a certificate that can be redeemed for a certain dollar amount of telephone calls. The company sells the certificates to merchandisers on a cash basis. Over time the merchandisers pass them out in promotions. The company suffers costs only when it receives a bill from the telephone vendor it has contracted to handle the calls. Because the company knows precisely its cost of goods sold, the owner can take home a portion of sales even before the product is produced. Best of all, a predictable percentage of certificates will be lost or destroyed before they're redeemed; then 100% of cash from sales flows into profit, since there's no cost of goods sold.

Cost of goods sold is a major cash-flow concern for manufacturers and retailers, however. The cash that pays for goods sold is channeled into inventory, where its flow is dead-ended until the inventory is sold and the cash is set free again. The cash-flow trick is to commit just enough cash to inventory to meet demand. Some manufacturers meet the challenge by just-in-time purchasing of inventory, thus tying up as little purchasing power as possible.

But virtually all available purchasing power goes into a retail store's inventory. A store that can't offer a wide range of choices loses sales to a store that can. Cash flow determines how much inventory can be safely carried while allowing for operations. A store intends to cycle cash in and out of inventory as many times as it can during the year. Of course, you could buy a whole year's worth and put it in the warehouse, but there goes cash flow: you'd pay for the inventory in January and wait until December to get all your money back out.

A store that resells inventory 24 times a year (as some stereo stores are said to do) need keep only a half-month's worth of projected sales in stock before enough cash comes back to pay for the next half-month's worth. But a retailer turning inventory only three times a year has to purchase sufficient stock to meet four months' worth of projected demand. With cash sitting on a shelf doing nothing for those 120 days, that retailer would seek suppliers whose payment terms extend to 120 days. Then the retailer has to spend none of its own cash; it becomes the supplier's cash that's sitting idly on the shelf. (And it might not even be the supplier's cash; probably it's a bank's. A supplier offering lengthy payment terms to attract your business is likely to be financing receivables to get its cash back into play, too.)

Another tried-and-true source of dirt-cheap working capital exists in the period between the time you send a creditor a check and the time that check clears at your bank. The sum involved in that hiatus is called float, and since it's up for grabs, many operations grab it. To exploit the cash-flow leverage of float, a business invests cash into interest-bearing accounts until the checks it has written are expected to clear. (Most banks will do that for you.) A check sent to California from New York State takes about six days to debit your cash account -- three days to get there, another day for the supplier to record and deposit it, another two days to pass through the banking system. That expanse of time has been getting shorter owing to faster mail delivery and electronic transfers, but float players still count on gaining a week's productive use of cash.

Costless capital created from thin air is best, naturally. Yet today entire industries exist thanks to a belief that not only is it worth it to have to pay for capital, but even if you have to pay through the nose, it's still worth it. The country's garment manufacturers have been capitalized for two centuries by money borrowed at rates that other industries would spurn as usurious -- even up to 20% or 30%. The cash flow they generated by squeezing cash instantly out of receivables and leaving it to their factors to collect went toward more productive ends than supporting accounts-receivable departments of their own.

Cash-flow strategy holds that you don't necessarily borrow because you don't have your own cash to spend, but because you choose to spend elsewhere the cash you have (the challenge being, of course, that when payments are due, there'd better be enough left to meet them). Thus forward-looking cash-flow analysis recognizes the significant differences among debt-service arrangements that may call for interest plus principal, interest only, ballooning schedules, revolving credit lines, and so on.

Financing our $10,000 computer, for instance, may become more attractive if it's done not with company cash but through borrowing. Some companies can take out an interest-only loan at a point and a half over prime. Most business loans aren't likely to be that cheap, but home equity loans are. Few small-business people, however, are comfortable placing personal property on the line. Nonetheless, cash-flow what-ifs of various borrowing schemes may dictate that such loans can be virtually riskless -- save for a crash of all financial markets, in which case ev-eryone's wiped out.

The problem with loans, of course, is that you have to pay them back. Most growing businesses don't concern themselves with putting aside cash with which to pay back a loan on its due date. For one thing, earnestly parking cash in some low-yielding money market would hinder survivability to that due date. Says one insouciant cash-flow strategist: "The time to start thinking about taking care of a five-year loan is in its 59th month. And you don't think how you're going to repay it; you think how you'll renegotiate it. Any loan you've ever taken out can be renegotiated and lengthened, as long as you're in business and profitable." The gentleman is so confident he'll remain in business and stay profitable that he regards term loans as his own money -- a permanent component of cash-flow working capital.

Now there's a businessperson who gets it: in the day-to-day course of running a company, other people's capital flows past an imaginative CEO as opportunity. By looking forward and keeping an analytical eye on your cash account as events unfold (remembering that if there's no real cash there when you need it, you're history), you can generate leverage as surely as if that capital were yours to keep. The only difference between the entrepreneurial kind of capital we're ending this piece with and the auditing kind we started with is that the former isn't an income-statement item. But it's equally spendable.

Last updated: Mar 1, 1993




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